Where next for Japan?

In a few days dominated by sharp falls on Wall Street, positive factors behind last year’s big rises for Japanese shares – such as rapidly increasing corporate earnings – seemed to quickly fade in significance. Like the Dow Jones in America, the Nikkei 225 Index has been volatile this week. Did Japan’s stock market run ahead of itself last year?

One thing world stock markets have shown amply this week is that, in the short term at least, investor sentiment coupled with market interconnectedness is king. A sudden desire to sell shares on Wall Street was easily replicated in other markets that have participated in the recent strong upswing in global share prices.

Diversification works, but it takes longer to play out. It benefits from a reasoned examination of differing fundamentals over time. Sharp market corrections are driven by crowd instincts that trump everything else.

When investors do return to Japan’s fundamentals, they will find them to be positive and improving. The latest survey of Japan’s service sector companies published by IHS Markit on Monday showed increases in new orders, more staff hiring and business confidence rising to its highest in 56 months in January1.

Japan’s exports have been firing on all cylinders too and spectacularly so in the case of China. Shipments to China soared 20.5% last year and by 11.8% to the rest of the world overall2.

No wonder then that confidence among Japan’s large manufacturers is also brimming over. The Bank of Japan’s latest quarterly “Tankan” survey showed their confidence rising to an eleven-year high3.

The signals from business suggest another positive corporate results season lies ahead after four consecutive quarters of strong profits growth for manufacturers and respectable improvements in profitability among non-manufacturers4.

Notwithstanding the capacity global markets have to trigger price events in one another, such information is inconsistent with the idea Japanese shares are starting to discount more difficult economic times ahead.

One potential positive arising from the turbulence in markets this week is that it may now be marginally less likely that Japan’s key benchmark interest rate of -0.1% will be easily given up.

Even before Monday’s market falls, Prime Minister Shinzo Abe had chosen to start the week saying he hoped Japan’s current policy on interest rates would be maintained, even going so far as to say Japan has yet to emerge decisively from deflation (negative inflation)5.

Bank of Japan Governor Haruhiko Kuroda was quick to respond on Tuesday, saying rates would stay the same and not be lifted just to create future policy space – central bank speak for having interest rates high enough so that they can be cut if the economy gets worse6.

While worries about rising inflationary pressures in America may have triggered market falls this week, Japanese inflation was just 0.9% in December, well below the government’s 2% target7.

Indeed, fragile inflation suggests a proposed rise in VAT from 8% to 10% in 2019 – part of a prolonged effort to reduce Japan’s huge public debt – remains a risky strategy. An increase from 5% to 8% in April 2014 proved counterproductive because consumers just spent more to beat the rise then reigned in spending afterwards, triggering a brief recession.

In a demonstration perhaps of the non prevalence of excessive wage pressures in Japan’s economy, Prime Minister Abe is calling for private sector companies to increase pay by 3% or more this year8.

In a world of rising US interest rates and central banks on paths to reversing the extraordinary measures put in place after the global financial crisis, Japan would appear to have quite a lot to single it out in a positive way.

The Bank of Japan may be the world’s only major central bank still accumulating domestic government bonds by the end of this year. Moreover Japan’s stock market continues to trade at a discount to its international peers based on the earnings companies are expected to achieve in 20189.

Fidelity’s Select 50 list of favourite funds contains four dedicated to Japan. The Schroder Tokyo Fund, which can be bought either hedged or unhedged against movements in the yen, invests in some of Japan’s largest, globally recognised names. Current top-10 holdings include Toyota, Bridgestone and TDK.

An alternative is the Baillie Gifford Japanese Fund, which emphasises Japan’s high-tech advantage with, for example, about a fifth of its assets invested in the technology sector as at the end of November.

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